Research Tax Credit

Documentation Requirements By Functional Areas For Research Credit

Substantiating Research Credit Expenditures by Functional Area

Two of our recent articles have focused on dResearch Tax Creditifferent aspects of the research credit under Internal Revenue Code (IRC) §41 which rewards taxpayers for engaging in qualified research activities by providing a tax credit equal to a percentage of certain eligible expenses. The first article focused on the new internal-use software regulations and provided a concise background description of the research credit under IRC §41. The second article brought attention to the four-part test for determining if expenditures qualify for the research credit and the documentation necessary to substantiate the expenditures to Internal Revenue Service (IRS) representatives in the context of an audit.

This article continues the basic theme of the second article by focusing on substantiating research credit expenditures of certain functional areas in a business organization. The specific focus will be on the production, quality control, administrative, and marketing functions of an organization as the IRS typically looks warily on such expenditure claims due to statutory and regulatory language.

Production

According to IRC §41(d)(4)(A), qualified research does not include “any research after the beginning of commercial production.” Under regulations to IRC §174, production costs are defined as “costs paid or incurred in the production of a product after the elimination of uncertainty concerning the development.” As indicated in our previous article, as part of the four-part test the IRC §174 states that the taxpayer must incur with intent to “discover information that would eliminate uncertainty concerning the development or improvement of a product.” Based on this statutory and regulatory language the IRS tends to reject many research expenditure claims attributable to production department cost centers.

However, in many firms employees in the production department often play a significant role in designing and verifying the manufacturing process and building pilot units and prototypes. The construction of a pilot unit can clearly qualify as a research expenditure as the definition under the regulations to IRC §174 states that “pilot model means any representation or model of a product that is produced to evaluate and resolve uncertainty concerning product during development or improvement.”

Project plans typically provide strong evidence of the involvement of the production department in the qualified research, especially when such a document identifies the departments or cost centers responsible for building prototypes or other production related aspects of the research. Additionally, taxpayers should consider having production department managers prepare memos highlighting their efforts with regard to pilot and prototype builds.

Quality Control

As indicated in IRC §41(d)(4)(D) and corresponding regulations, qualified research expenditures do not include routine ordinary testing or inspection for quality control. This leads IRS agents to frequently challenge research expenditures associated with quality control as they assume such personnel merely conduct “routine” quality control. However, the IRC §174 regulations specifically state that expenditures incurred “to determine if the design of the product is appropriate” qualify for the research credit.

Quality control departments can participate in component testing and design qualification analysis, or provide support to design engineers in other ways. Thus, business organizations should thoroughly document such qualifying activities in order to take full advantage of the research credit.

Administrative

The IRS often calls into question claims for research expenditures attributable to upper-management as it views these employees as being too far removed from actual research activities. IRC §41(b)(2)(B) defines qualified research services to include direct supervision of those engaging in qualified research. The corresponding regulations add that direct supervision “means the immediate supervision (first-line management) of qualified research … [but] does not include supervision by a higher-level manager to whom the first-line managers report, even if that manager is a qualified research scientist.” However, in some cases upper-level management does either perform direct research or directly manages the research itself. The business should likewise carefully document these activities to maximize its claim for the credit.

Project plans are important in supporting research expenditure claims for administrative employees, especially if the document highlights the wide array and complexity of all testing processes. This complexity will demonstrate the importance of this direct administrative oversight. A project organizational chart can also document the project reporting hierarchy.

Marketing

According to IRC §41(d)(4)(D), qualified research expenditures do not include “market research, testing, or development (including advertising and promotion).” This explicit statutory language usually causes IRS agents to blindly reject research expenditures claimed for all marketing related cost centers. However, in some companies marketing professionals have an important role in the early concept development stages and work closely with design teams and engineers to develop new technologies and product features. Design engineers need to know what customers want prior to or during development.

Organizations should therefore precisely document the participation of marketing personnel in the design and early development stages. Well-designed documents such as marketing needs assessments or design concept assessments can provide useful substantiation in that regard. Attendance sheets or distribution lists related to project review meetings should therefore include those marketing personnel directly involved in the research projects.

For more information on the research credit and how to ensure that your business is documenting expenditures for the credit effectively please contact a tax professional.

 

About The Author

Daniel Quintana

Daniel Quintana of Kurtz & Company, P.C. in Dallas Texas.
https://www.linkedin.com/in/drquintana